Securities in scope and in trading mechanics have enormous breadth. In scope, securities naturally include conventional stocks and bonds but have the far more expansive notion today of virtually any financial instrument. For example securities will include futures on tangible commodities such as agricultural products. But futures themselves today will cover a wide range of tangible and intangible items ranging from interest rates to stocks to stock indices to foreign currencies and to pollution rights. Securities may also include so-called “derivatives” other than futures, e.g. options in all their varieties. We define a financial instrument as an instrument that may be bought or sold for money on an exchange, regardless of the underlying security, commodity, good or service. An exchange is any place where a market is made for such instrument an instrument.
The mechanics of trading are also enormously complex. Trades may be made in formal exchanges, if “listed” or, if “unlisted” over a network commonly known as the “Over-the-Counter” (“OTC”) market. In the case of formal exchanges and for some networks, an important role in trading mechanics is played by a “clearinghouse” or, synonymously in this disclosure, a “clearing system.” Depending upon the exchange and the type of security, the exact role of the clearing system will vary.
Most stocks are sold the “regular way,” which requires delivery of certificates within three business days. It would be extremely inefficient if every security transaction had to end with a physical transfer of stock certificates from the seller to the buyer. A brokerage firm might sell on the New York Stock Exchange 100 shares of IBM stock for one client, Mr. X, and later that day buy 100 shares for Ms. Y, another client. Mr. X's 100 shares could be delivered to his buyer, and Ms. Y's shares could be obtained by accepting delivery from her seller. However, it would be much easier to transfer Mr. X's shares to Ms. Y and instruct Ms. Y's seller to deliver 100 shares directly to Mr. X's buyer. This route would be especially helpful if the brokerage firm's clients, Mr. X and Ms. Y, held their securities in street name. Then the 100 shares would not have to be moved and their ownership would no have to be changed on the books of IBM.
The process can be facilitated even more by a clearing system, the members of which are brokerage firms, banks, and other financial institutions. Records of transactions made by members during the day are sent there shortly afterward. At the end of the day, both sides of the trades are verified for consistency, and then all transactions are netted out. Each member receives a list of the net amounts of securities to be delivered or received along with the net amount of money to be paid or collected. Every day each member settles with the clearinghouse instead of with various other firms.
By holding securities in street name and using clearing systems, brokers can reduce the cost of transfer operations. But even more can be done: certificates can be immobilized almost completely. The Depository Trust Company (“DTC”) immobilizes certificates by maintaining computerized records of the securities “owned” by member firms (brokers, banks, and so on). Members' stock certificates are credited to their accounts at the DTC, while the certificates are transferred to the DTC on the books of the issuing corporation and remain registered in its name unless a member subsequently withdraws them. Whenever possible, one member will “deliver” securities to another by initiating a simple bookkeeping entry in which one account is credited and the other is debited for the shares involved.
Trading in futures contracts is more complex than making ordinary stock transactions. If an investor wants to make a stock purchase, his broker simply acts as an intermediary to enable the investor to buy shares from or sell to another individual through the stock exchange. In futures trading, however, the clearinghouse plays a more active role.
When an investor contacts a broker to establish a futures position, the brokerage wires the order to the firm's trader on the floor of the futures exchange. In contrast to stock trading, which involves specialists or market makers in each security, most futures trades in the United States occur among floor traders in the “trading pit” for each contract. Once a trader willing to accept the opposite side of a trade is located, the trade is recorded and the investor is notified.
At this point, the clearing system enters the picture. Rather than having the long and short traders hold contracts with each other, the clearinghouse becomes the seller of the contract for the long position and the buyer of the contract for the short position. The clearing system is obligated to deliver the commodity to the long position and to pay for delivery from the short; consequently, the clearinghouse's position nets to zero. This arrangement makes the clearing system the trading partner of each trader, both long and short. The clearinghouse, bound to perform on its side of each contract, is the only party that can be hurt by the failure of any trader to observe the obligations of the futures contract. This arrangement is necessary because a futures contract calls for future performance, which cannot be as easily guaranteed as an immediate stock transaction.
FIGS. 1 and 2 illustrate the role of the clearing system in a futures transaction. FIG. 1 shows what would happen in the absence of the clearinghouse. The trader in the long position 101 would be obligated to pay the futures price 105 to the short position trader 111, and the trader in the short position 111 would be obligated to deliver the instrument or security or commodity 115. FIG. 2 shows how the clearing system 121 becomes an intermediary, acting as the trading partner for each side of the contract. The clearinghouse's position is neutral, as it takes a long 125 and a short position 131 for each transaction.
The clearing system makes it possible for traders to liquidate positions easily. If an investor is currently long in a contract and wants to undo his or her position, the investor simply instructs the broker to enter the short side of a contract to close out his or her position. This is called a reversing trade. The exchange nets out the investor's long and short positions, reducing his or her net position to zero. The zero net position with the clearinghouse eliminates the need to fulfill at maturity either the original long or reversing short position.
The open interest on the contract is the number of contracts outstanding. (Long and short positions are not counted separately, meaning that open interest can be defined as either the number of long or short contracts outstanding.) The clearing system's position nets out to zero, and so is not counted in the computation of open interest. When contracts begin trading, open interest is zero. As time passes, open interest increases as progressively more contracts are entered. Almost all traders, however, liquidate positions before the contract maturity date.
Instead of actually taking or making delivery of the commodity, market participants virtually all enter the reversing trades discussed above to cancel their original positions, thereby realizing the profits or losses on the contract. The fraction of contracts that result in actual delivery is estimated to range from less than 1% to 3%, depending on the commodity and the activity in the contract.
In a typical pattern of open interest, for example, in November the December delivery contract is close to maturity, and open interest is relatively small; most contracts have been reversed already. The next few maturities have significant open interest. Finally, the most distant maturity contracts have little open interest, as they have been available only recently, and few participants have traded. For other contracts, where January or February is the nearest maturity, open interest is typically highest in the nearest contract.
In fact, traders simply bet on the futures price of the underlying commodity. The total profit or loss realized by the long trader who buys a contract at time 0 and closes, or reverses, it at time t is just the change in the futures price over the period, Ft−F0. Symmetrically, the short trader earns F0−Ft.
The process by which profits or losses accrue to traders is called marking to market. At initial execution of a trade, each trader establishes a margin account containing “initial” or “performance” margin. The margin is a security account consisting of cash or near-cash securities, such as Treasury bills, which ensures the trader is able to satisfy the obligations of the futures contract. Because both parties to a futures contract are exposed to losses, both must post margin. One example is a contract for corn for $1138.75 ($2.2775 per bushel×5,000 bushels per contract). If the initial margin on corn, for example, is 10%, then the trader must post $1,138.75 per contract for the margin account. Because posting interest-earning securities may satisfy the initial margin, the requirement does not impose a significant opportunity cost of funds on the trader. The initial margin is usually set between 5% and 15% of the total value of the contract. Contracts written on assets with more volatile prices require higher margins.
On any day that futures contracts trade, futures prices may rise or may fall. Instead of waiting until the maturity date for traders to realize all gains and losses, the clearinghouse requires all positions to recognize profits as they accrue daily. If the futures price of corn rises, the clearing system credits the margin account of the long position for the amount of the rise. Conversely, for the short position, the clearinghouse takes this amount from the margin account for each contract held. This daily settling is called marking to market. It means the maturity date of the contract does not govern realization of profit or loss. Marking to market ensures that, as futures prices change, the proceeds accrue to the trader's margin account immediately.
If a trader accrues sustained losses from daily marking to market, the margin account may fall below a critical value called the maintenance, or variation, margin. Once the value of the account falls below this value, the trader receives a margin call. For example, if the maintenance margin on corn is 5%, then the margin call will go out when the 10% margin initially posted has fallen about in half, to $569 per contract. Either new funds must be transferred into the margin account, or the broker will close out enough of the trader's position to meet the required margin for that position. This procedure safeguards the position of the clearing system. Positions are closed out before the margin account is exhausted; the trader's losses are covered, and the clearinghouse is not affected.
It is important to note that the futures price on the delivery date will equal the spot price of the commodity on that date. As a maturing contract calls for immediate delivery, the futures price on that day equals the spot price-the cost of the commodity from the two competing sources is equalized in a competitive market. The investor may obtain delivery of the commodity either by purchasing it directly, in the spot market or by entering the long side of a futures contract. This is called the convergence property.
For an investor who establishes a long position in a contract at time 0 and holds that position until maturity (time T), the sum of all daily settlements will equal FT−F0, where FT stands for the futures price at contract maturity. Because of convergence, however, the futures price at maturity, FT, equals the spot price, PT, so total futures profits also may be expressed as PT−F0. Thus, profits on a futures contract held to maturity track changes in the value of the underlying asset.
Most futures markets call for delivery of an actual commodity such as a particular grade of wheat or a specified amount of foreign currency if the contract is not reversed before maturity. For agricultural commodities, where quality of the delivered good may vary, the clearing system or exchange sets quality standards as part of the futures contract. In some cases, contracts may be settled with higher—or lower—grade commodities. In these cases, a premium or discount is applied to the delivered commodity to adjust for the quality difference.
Some futures contracts call for cash delivery. An example is a stock index futures contract where the underlying asset is an index such as the Standard & Poor's 500 or the New York Stock Exchange Index. Delivery of every stock in the index clearly would be impractical. Hence, the contract calls for “delivery” of a cash amount equal to the value that the index attains on the maturity date of the contract. The sum of all the daily settlements from marking to market results in the long position realizing total profits or losses of ST−F0, where ST is the value of the stock index on the maturity date T, and F0 is the original futures price. Cash settlement closely mimics actual delivery, except the cash value of the asset rather than the asset itself is delivered by the short position in exchange for the futures price.
Futures margins are different from stock margins. The margin requirement for a stock earlier discussed is essentially a down payment for a security to be owned. The investor who trades on margin has all the rights and privileges of an outright owner. This is not true with futures contracts. When a stock is purchased, the new owner assumes control over the voting rights, whereas with futures contracts only price risk is transferred. Also, because of daily mark to market, the need for enormous collateral on futures contracts is minimized. A futures margin is just a performance bond that insures that both parties will fulfill their obligations.
The clearinghouse plays a key role in futures trading. The clearing system guarantees both sides of a futures contract. The clearinghouse not only helps eliminate default risk but also guarantees the quality of the goods delivered. Most commodity futures contracts have a specified quality level, and the clearing system makes sure that a commodity of the appropriate quality is delivered.
The clearinghouse also facilitates the exchange of daily cash flows between the winners and the losers. It makes sure that both the buyer and the seller of futures contracts provide adequate collateral. As was seen the clearing system requires brokers to impose initial margin requirements on both buyers and sellers, mark to market the accounts of buyers and sellers every day, and impose daily maintenance margin requirements on both buyers and sellers.
The clearinghouse thus plays at least four vital roles in futures transactions:
1. Banker. The clearing system provides for the exchange of profits and losses.
2. Inspector. The clearinghouse insures good product delivery.
3. Insurer. The clearing system guarantees that each trader will honor the contract.
4. Liquidity maintainer. The clearing system facilitates “reversing trades”.
Option trading occurs on exchanges, over the counter, and directly between buyers and sellers. There are many different exchanges on which options are traded. The most active option exchanges are the Chicago Board Options Exchange (CBOE), the American Stock Exchange (AMEX), the Chicago Board of Trade (CBOT), the Philadelphia Stock Exchange (PHLX), the Chicago Mercantile Exchange (CME), and the Pacific Stock Exchange (PSE).
Option transactions are similar to stock transactions. For example, if Mr. Q decides to buy call options on Compaq, he would call his broker and state his desires. The broker would communicate this order to the appropriate option exchange, where the trade would occur with either an investor wanting to sell call options on Compaq or with the market maker.
The Options Clearing Corporation (“OCC”) maintains the records of option trades and is one of the major clearinghouses. The OCC is owned and backed by several exchanges (such as the CBOE, AMEX, NYSE, and PHLX). Hence, the OCC is a very creditworthy corporation. Similar to what was seen for futures clearinghouses, the OCC issues all option contracts and guarantees both sides of the contracts. Thus, the option buyer does not have to evaluate the credit risk of the option writer. Also, all option contracts have standardized features that make them easier to resell, thus enhancing the option contract's liquidity. The OCC processes all transactions related to option trading and imposes margin requirements on options writers (i.e., sellers).
The OCC makes it possible for buyers and writers to close out their positions at any time. If a buyer subsequently becomes a writer of the same contract, meaning that the buyer later “sells” the contract to someone else, the OCC computer will note the offsetting positions in this investor's account and will simply cancel both entries. Consider an investor who buys a contract on Monday and then sells it on Tuesday. The computer will note that the investor's net position is zero and will remove both entries. The second trade is a closing sale because it serves to close out the investor's position from the earlier trade. Closing sales thus allow buyers to sell options rather than exercise them. This process serves the same purpose as “reverse trades” in a futures transaction and facilitates market liquidity.
When an optionholder exercises an option, the OCC arranges for a member firm with clients who have written that option to make good on the option obligation. The member firm selects from its clients who have written that option to fulfill the contract. The selected client must deliver, for example, 100 shares of stock at a price equal to the exercise price for each call option contract written or must purchase 100 shares at the exercise price for each put option contract written.
Clearly, securities transactions are hampered in their efficient follow-through by the multiplicity of clearing systems. The commonality of many of the functions of the different clearinghouses suggests that numerous clearing systems can be combined and service different exchanges or even different types of exchanges, e.g., exchanges on which futures and options are traded. Thus, inefficiencies associated with duplication of function exist.
In addition, the existence of multiple clearinghouses means that a single customer's collateral or margin must be available at many clearing systems. This duplication of margin occurs even if the combined amount of that customer's margin exceeds the aggregate amount of risk borne by the multiple clearinghouses.
Moreover, communication techniques between the exchanges and the clearing systems are frequently structured in batch fashion. Information about trades will be communicated once daily or at selected intervals during the days, e.g., after periods of hours or minutes. This delay in communication can produce numerous inefficiencies. For example, if a trade, not yet reported to the clearinghouse, reduces the risk of the customer's position, the clearing system will be over-collateralized and the customer may not have the collateral available to support other transactions until the information is transmitted to the clearinghouse. Conversely, if the trade increases the risk of the customer's position, the clearing system will be under-secured for a period of time. Delays in communication can also lead to increased risk with real costs. An example of a risk is a delivery or risk that is caused by someone on one side of a trade being unable to pay for or deliver what was sold.
What is needed therefore is a system that links multiple financial exchanges, trading a variety of securities, to a single clearing system. What is also needed is immediate communication of trading information to the clearing system.